middle market


dog-bowlBeing early, wrong, or both is no fun, at least not in the case of making industry predictions (traders will also say early is also wrong).  And when it comes to our views on the waning of the pet food upgrade cycle many people have made us aware that we were either early or wrong (or both!).  However, when you make market predictions based on limited information you are going to be wrong, sometimes with regularity (see my view on the inability for private equity to acquire PetSmart here, as just one notable example where I have missed the mark, but at least I correctly predicted that they would not combine with Petco, see here), and we are okay with that.  That said, here I am not sure we were either wrong or even that early in this case.

In 2013, we began to beat the drum about the deceleration of the pet food upgrade cycle (for those of you scoring at home you can see comments here and here).  Our view was that basic economic realities were fundamental headwinds — stagnant wage growth, slowing pet replacement, growth in small dog ownership, and continued food price inflation.  We then pointed to PetSmart comps going flat to negative, and fully negative ex-inflation, for most of 2014, had to be a sign this cycle was on life support.  However, all of these factors were explained away by other data — accelerating pet product Personal Consumption Expenditures in 2015 (Bureau of Economic Analysis), recovering pet adoptions in 2015 (PetPoint), accelerating pet food spend in 2015 (APPA), growth in alternative form factor pet food (GfK), mismanagement at PetSmart (pick your favorite equity analyst), and the successful Blue Buffalo IPO.  In short, for every fundamental premise we had on the offer, there was a data set that one could point to bolster their thesis.  The issue was that the evidence used to perpetuate the myth that the upgrade cycle was alive and well was easy to debunk, but nobody want to hear it, and they still don’t.

Fast forward to today, and we now see increasing direct evidence that supports our thesis.  First, last month The J.M. Smucker Company trimmed its full year earnings forecast on the basis of declining sales of pet food for the quarter, down 6%. While there was a positive spin around the narrative (difficult comps due to prior year sell-in, strong new brand sales prior year), it is concerning.  The company expects weakness to persist throughout the balance of the year.  Second, our survey of private mid-market pet food marketers ($100+ million in revenue) indicates that the malaise Smucker’s is experiencing is not isolated, though the magnitude is greater.  Most of the company’s we surveyed offered full year views of 0% – 2% growth domestically. Finally, Tractor Supply, which does a significant percentage of its business in livestock and pet supplies (44%), trimmed its quarterly earnings forecast and full year outlook for the second time this year.  The company now expects same-store-sales for the quarter to be flat to down 1% after being up 2.9% in the prior year period. While we may not think of Tractor Supply as the prime destination for the premium pet food consumer, they do sell a considerable number of premium brands – Blue Buffalo, Merrick, Natural Balance, and Wellness, among others.  The company pointed to slowing growth in the C.U.E. (consumables, usables, edibles) business. Translating the semantic hieroglyphics, this means their pet and animal products business, including pet food.  We suspect Tractor Supply is not alone.

What is more important here than being right or wrong as it relates to the state of pet food, is what will the implications be for the capital markets of the death of the cycle.  We do not believe that slowing pet food sales, premium or otherwise, is going to hamper capital formation. There remain multiple heuristics of emerging brands garnering footholds to grow their business rapidly to $25 – $50 million in sales with limited capital investment.  The scarcity of these businesses, coupled with the amount of institutional capital chasing these opportunities, means that growth equity investments in pet food, distinct from treats, will remain robust.  Of greater significance is whether this will jump start a new M&A cycle.  While large strategic acquirers tend to have a negative M&A bias during period of weak financial performance, it might just be such that they will uses these events to recognize the need to buy into niches that represent the future of the industry.  This could push multiples, which have been waning, albeit, at the margins over the past three years to begin to trend up.  Further, the fact that broader M&A statistics indicate we are almost certainly at the end of this M&A cycle, might cause more sellers to come to the table.  Watch closely for M&A volume in this segment to tick up over the coming year.

/bryan

Note: This blog is for informational purposes only. The opinions expressed reflect my view as of the publishing date, which are subject to change.  While this post utilizes data sources I consider reliable, I cannot guarantee the accuracy of any third party cited herein.

 

 

 

 

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mockingjayEarlier this month, Petco Animal Supplies and PetSmart stores in Topeka, Kansas, and adjacent Lawrence, Kansas, removed from their shelves Hill’s Science Diet and Ideal Balance products.  Store managers have been telling customers that the brands is not coming back on shelf.  Notably, Hill’s Pet Nutrition, a subsidiary of Colgate Palmolive, is headquartered in Topeka.

Consider the above action a shot across the bow in the dynamically evolving landscape of pet food retail.  To better understand the future, and what this gambit might mean, one must begin with a look at the past.

Hill’s Pet Nutrition was founded in 1907. The company started in the rendering business.  By 1930, the company had evolved into packing company, producing animal feed, dog food, and horsemeat for human consumption in Norway, Finland, and Sweden.  In 1948, Dr. Mark Morris contacted Hill’s seeking a producer for Canine k/d, his brand of healthy scientifically engineered pet food.  In 1968, Canine k/d was made available to veterinarians as Hill’s Science Diet.  The brand evolved into a broad line of prescription and breed specific solutions available through veterinarians and pet specialty retailers.  In 1978, Hill’s became part of the Colgate family through a merger of Hill’s parent company.  In 1999, Hill’s sales reached $1 billion.

What is particularly significant was the fact that Hill’s was at the forefront of the healthy pet food revolution, albeit with a scientific approach. Further, long before there was Blue Buffalo, Hill’s, along with Nutro, was one of the biggest drivers of customer traffic to pet specialty retailers on the market.  Thus, for Petco and PetSmart to declare war on Hill’s is, for lack of a better term, A BIG DEAL.

The makings of this feud can be traced back five years.  Beginning in 2011, Hill’s pet food sales began to stagnate.  The company, whose products evoked images of white lab coats and engineers, found itself on the wrong side of a change in consumer preference, and therefore purchase intent.  Instead of favoring science based nutrition solutions, pet owners began to favor products whose ingredient panels best mirrored their own diet.  White lab coats were replaced by images of roasted turkey, market vegetables, and whole grains.  Natural triumphed over engineered.

Hill’s, being part of a large consumer packaged goods firm, was not content to let its franchise slip away. The company tried to change with the market, launching Science Diet Nature’s Best, a naming convention approaching the absurd.  Not surprisingly the disconnect remained.  Hill’s responded with the launch of Ideal Balance, its “natural” solution, but was slow to win back customers. While Hill’s revenues had grown to $2.2 billion in 2015, this number represented essentially flat growth between 2011 – 2015.  To maintain sales, Hill’s embraced the internet as a channel.  In 2015, Hill’s represented 7.5% of online pet food sales, taking the third position behind Blue Buffalo (12.3%) and Wellness (9.0%).  It attained that position by turning a blind eye to the price discount pet food retailers where charging for its solution set, thereby drawing the ire of Petco and PetSmart.  And you understand why we-are-where-we-are.

One has to surmise that Hill’s knows quite well what it is doing and the consequences of its actions. My understanding is they have recently put pressure on major online retail sites to enforce their MAP policy based, in turn, on pressure from Petco and PetSmart. However, if Hill’s cannot get back in the good graces of its top premise based retailers, prepare to find Science Diet and Ideal Balance at big box store near you.  The likes of Target and Wal Mart would welcome Hill’s and its customer base with open arms. Whether this is a brilliant move by Colgate or the straw that breaks the brands back remains to be seen.

Of greater interest is what this means for Blue Buffalo.  A big box Hill’s is not going to be a welcome site for the veterinary community who drives the disproportionate sales of prescription diets and is a big influencer of Science Diet sales.  Blue Buffalo has staked the next leg of its growth stool on its veterinary line of products.  If Hill’s defects, that will create a fracture in the relationship between the company and the veterinary community that Blue Buffalo could be poised to exploit.  That’s not to say it won’t have fierce competition for that mind share from the likes of Royal Canin and Purina, but thirty days ago that market looked much tougher to crack.

Let the games begin.

/bryan

Note: This blog is for informational purposes only. The opinions expressed reflect my view as of the publishing date, which are subject to change.  While this post utilizes data sources I consider reliable, I cannot guarantee the accuracy of any third party cited herein.

 

 

 

phoenisThe pet industry stands at the precipice of a tactical sea change.  The industry entered into this transitional phase in 2014 and is expected to remain there through 2017.  The industry entered into this state as a result of slowing growth and macroeconomic headwinds.  The historical catalysts for growth — Baby Boomers as the driver of industry spend, pet food upgrade cycle, premise based retail — have waned.  However, the future change drivers — pet ownership among Millennials, grain-free and alternative form factor pet food, ecommerce, connected pet — are individually not yet sufficient to resurface the landscape. Yet we expect, after another year of gestation, these trends, will set of the next phase of industry growth, market share shift, and strategic acquisitions.

As we muddle through the tail end of this transitional phased, here are trends we are keeping an eye on in 2016:

  • Industry Offers More Upside Opportunity than Downside Risk. Despite the slowing sequential growth rate for the industry and the limited innovation in consumables, we believe the industry stands poised to outperform in 2016. Our premise relies on three factors. First, the acceleration in pet adoptions experienced in the 2H2015 will have a knock-on effect on pet spending in 2016 as these new owners generate a full year of expenditures and trade up to premium solutions. This adoption spike is consistent with the 2012 – 2013 period where growth was 4.5%, albeit from a smaller base. Second, while the pet food upgrade cycle may be running on fumes, a proliferation in food additives, convenience offerings, and premium cat solutions will provide the industry with a growth impetus. Finally, we view the macro economic stability for employment, wage growth, and consumer sentiment as remaining favorable through the balance of 2016.
  • Expect Transaction Velocity to Remain High. 2015 was a return to normalized transaction velocity levels for the industry after a two year hiatus. We expect transaction velocity will remain high in 2016 as consolidation themes continue and sellers try to take advantage of the tail end of the capital markets cycle. What will change is the types of deals that are getting done. In 2014 and 2015, the industry was the subject of a large number of headline grabbing transactions involving key industry names – Big Heart Brands, PetSmart, Petco, MWI Veterinary Supply.  Absent a sale of Champion Petfoods, we expect most of the velocity to be among companies valued at less than $250 million. Notably, the M&A rumor mill was at peak decibel levels at Global Pet Expo. However, the number of companies pursuing deals pursuant to organized processes appears lower, meaning the number of potential deals that could get done pursuant to one-off dialogs is elevated.
  • Consumables Lines Blurring in New Ways. Five years ago, the thought of a pet treat business being able to bridge into pet food was unthinkable. Today there exist a myriad of treat brands which have developed a trusted connection with consumers in the pet specialty channel that might allow them to make that leap. Notably, several of these brands launched food solutions at Global Pet Expo to very favorable retailer response. While it is unclear if and how quickly these solutions can scale, it speaks to the fact that the delineation between food and treat brands continues to decrease.  As premium pet food companies find market share gains harder to come by, we expect they will seek to expand sales volume through increased treat offerings and acquisitions of treat companies. Further, treat company valuations will benefit from buyers factoring in potential product line extensions into food, though not all brands will benefit.
  • Ecommerce Landscape Changes Ahead. Sales of pet products continues to grow online fueled by price based competition and increased convenience. The impact of growing online sales can been seen acutely in the comps of Petco and PetSmart prior to their representative transactions. However, the pain has spread to the independent channel as well, as more brands have embraced ecommerce as a driver of growth and customer acquisition. In response, retailers are putting pressure on manufacturers to enforce MAP policies or, in some cases, choose sides. However, many of the brands caught in the battle among retail formats are not well equipped to do either. Assuming that Chewy.com continues to find fuel for its growth, and that Jet.com continues to find brands willing to embrace its platform, this problem will grow. Pressuring brands will not solve the problem. Rather, the winners in retail will be those who deliver the best consumer service experience as measured by selection, price, and convenience. Independent retailers will need to develop capabilities that enable their customers to shop online and get accelerated delivery, presenting an opportunity for distributors to fill this void.

 

As always, a complete copy of our 2016 industry report is available by email.

/bryan

Note: This blog is for informational purposes only. The opinions expressed reflect my view as of the publishing date, which are subject to change.  While this post utilizes data sources I consider reliable, I cannot guarantee the accuracy of any third party cited herein.

 

dwarfEarlier this week it was announced that Mars Petcare had acquired Whistle Labs, designer and marketer of activity monitoring and asset tracking solutions for small companion animals.  The deal was valued at $117 million (or $119 million depending on the source of information).  Whistle had raised $25 million in outside capital, including $21 million in two institutional rounds, including a $15 million Series B round in January 2015, led by Nokia Growth Partners.  The Series B also including participation from, among others,  Melo7 Tech Ventures (the equity fund of Carmelo Anthony, NBA superstar) and QueensBridge Venture Partner (the equity fund of Nasir Jones, world famous rapper).  The post-money on the Series B was reported to be $26.65 million, meaning these investors made a ~ 4.5x cash-on-cash return on the sale and triple digit internal rate of return based on the short duration.

When Whistle launched its solution set the market was bifurcated between activity monitoring and asset tracking.  The asset tracking side was being addressed largely by companies that were re-purposing technology that had been deployed in more traditional markets, such as logistics, automobile tracking, or human tracking (yes these do exist).  However, these companies did not necessarily recognize the emotional engagement aspects of the pet space, and did little to build community.  The network costs of these businesses were high, and the user base was small.  Given that the initial hardware purchase was subsidized, these businesses lost money, sometimes large amounts of it.  Further, there was no effective retail channel for this class of products as the major pet specialty retailers were not well situated to sell a $200 device with a monthly subscription attached thereto or explain the value proposition effectively to customers, and therefore the market was slow to emerge. Traditional channels, such as consumer electronics and mobile phone centers, were no more effective at attracting pet owners let alone articulating the purchase rationale.  It did not help that most of these solutions had large form factors and minimal visual appeal.

In contrast, Whistle brought to market an activity tracker with a high level of aesthetic appeal at a much lower cost.  Of significance, gone were the monthly subscriptions.  The problem was the market wanted asset tracking as the linkage between the activity monitor and the benefits use case was just not obvious to pet owners.  In short, there was data but not much to do with it and sharing it was cumbersome.  Much like the early human activity tracking sector, the real value of these devices did not emerge until the ecosystem and community aspect developed. Whistle would use part of its Series B financing to acquire Snaptracs, the Qualcomm based asset tracking solution that it spun out in 2013.  Using their industrial engineering acumen, Whistle combined the two solution sets into a best of breed offering and the business began to accelerate.

About the time of the Series B, Whistle began collaborating with Mars on the use cases of its device.  The challenge became how do you balance the venture capitalists agenda — drive brand, drive sales, drive community — with the Mars agenda around linking the data to wellness outcomes and product sales.  In the end, we believe Mars acquired Whistle to enable its agenda to become central to the future of the business.  Given that the lifetime value of a subscriber was high as the revenue was recurring, shareholder value increased exponentially.

While the acquisition and the prevailing purchase price will certainly give momentum to the connected pet space, the perceived rationale is somewhat vexing to rationalize.  Connected pet solutions that have been funded and launched into the market over the past few years have focused more on emotive connections (remote viewing, remote treating, automated feeding) than wellness outcomes, and here we have an acquisition rationale that we believe is tied more to healthcare outcomes than humanization. That is not to say the deal won’t be effective in catalyzing more investment and further M&A; the return profile will ensure that happens.

This deal very much validates the space, and we have been on record suggesting more large consolidators get into connected pet since 2013, when we marketed the Snaptracs business for sale.  We believe other large players will have to take notice and find avenues to take a position in connected pet. Further, we think the Mars acquisition rationale is specific to them and does not require a pivot by other operators to enhance their focus on wellness.  Mars is unique in that it is the only enterprise that has both veterinary hospitals and branded companion animal consumables, and therefore could view Whistle in a unique way and justify the purchase price as a result. It does help that they are a very large private enterprise and do not have to kowtow to outside shareholders.

One of the key themes we witnessed at the most recent Global Pet Expo was a proliferation of solutions aimed at connecting owners to their pets wherever they were resident at the time — the home, the grooming salon, the daycare or dog walker, the boarding facility. etc.  Expect the Whistle deal to give them all more conviction and attract a host of new entrants seeking to capitalize on the market opportunity. Ultimately, pet owners stand to benefit most.

/bryan

Note: This blog is for informational purposes only. The opinions expressed reflect my view as of the publishing date, which are subject to change.  While this post utilizes data sources I consider reliable, I cannot guarantee the accuracy of any third party cited herein.

 

 

petcoOn November 23rd, CVC Capital Partners Limited and Canada Pension Plan Investment Board (the “Buyout Group”) signed a definitive agreement to acquire PETCO Animal Supplies, Inc. (“Petco”) from TPG Capital, L.P., Leonard Green & Partners, L.P., and friends for $4.6 billion. The deal values Petco at approximately 10.0x my pro-forma TTM Adjusted EBITDA for Petco as of October 31, 2015. This contrasts with the 9.0x TTM Adjusted EBITDA for the acquisition of PetSmart by BC Partners.  It is rumored that the Buyout Group was able to arrange approximately $3 billion of debt financing to support the deal.  Notably, both Petco and PetSmart will be owned by foreign investors assuming the deal closes.

It should come as no surprise that Petco opted for a private equity sale. Too much time had passed since the September 18th media leaks to believe a Petco / PetSmart combination would come together.  The case for public equity offering also faced numerous headwinds — a) broader stock market volatility driven by macro-political risk (Syria, ISIS, China), b) weaker than anticipated earnings among publicly traded retailers (as of November 20th over 40% of the retailers in the S&P 500 had posted earnings misses for 3Q2015), c) weak October retail sales (0.1% increase versus 0.3% consensus) and d) falling consumer confidence (lowest levels this year and a steep drop from October).  Against this backdrop, a trade sale was the most attractive option, even if debt market support for the deal had been choppy.  We generally consider 10.0X the break-point for specialty retailer M&A, above which history has not looked kindly on the buyer from a shareholder value creation standpoint.

The most pressing question now is who will lead the acquired organization going forward.  Jim Meyers, who has been in the CEO role since March 2004 (he was named Chairman earlier this year), and his team has lead Pecto back to a position of prominence.  Based on the S-1, Petco was posting stronger growth and better unit economics than its larger rival.  However, if history is a guide, large private equity deals seldom result in a staying of the course. In a small amount of irony, it is possible, though unlikely, that David Lenhardt could be running Petco a year after being ousted from PetSmart. Stranger things have happened.

If the Buyout Group is smart, they will purse incremental changes at Petco as opposed to a holistic approach to transformation. While there are certainly cost inefficiencies to be rung out of the system, Petco’s value is in how well it is currently situated from a growth standpoint with its greater emphasis on wellness, its multi-box positioning, its omnichannel reach and its under penetration in private label.  Further, with PetSmart deeply invested in its cost containment program, now is the time for Petco to press on the growth accelerator.  Someone is going to grab the brass ring and if not Petco, the chase will be led by Pet Supplies Plus, Pet Valu or a series of financially supported independent chains.

The next year should be an interesting one is large box pet retail land.  Regrettably we won’t be getting much transparency into either business any time soon.

/bryan

Note: This blog is for informational purposes only. The opinions expressed reflect my view as of the publishing date, which are subject to change.  While this post utilizes data sources I consider reliable, I cannot guarantee the accuracy of any third party cited herein.

 

 

 

 

 

dog bowelTracking growth in the pet industry has historically been a static exercise.  Industry observers have become beholden to annual disclosures from the American Pet Products Association (APPA) or one of the third party research organizations that track the industry’s performance (Packaged Facts, Mintel, GfK, etc.).  Garnering a read in between reporting mileposts has required the application of inference to lagging data.  The take private of PetSmart removed a valuable leg to the data stool on which many inferences relied. However, in the case of pet consumables, recent public offerings and acquisitions of major pet properties by public companies, provides us greater transparency from which to make educated guesses.  Consider the following August 13th reporting disclosures:

  • Nestle Purina disclosed segment level growth data for the first half of 2015 for all of its businesses (note, European public companies report on a half yearly basis).  The Petcare division delivered ~ $5.63 billion in Sales in 1H2015 (reflects conversion of CHF to USD as of the data of publication), up 4.9% over the same period in 2014.  Nestle also disclosed that its Petcare division increased Operating Income margin by 1.1%.  Healthy growth given the size of the numbers involved.
  • Blue Buffalo reported strong second quarter sales and earnings performance.  Sales for the quarter totaled $254 million, or 16% growth versus the same period in 2014. While earnings were up for the period by 14%, Blue Buffalo posted a 2.0% decline in Operating Income margin for 2Q2015.  Volume growth for the quarter was 15%, with dry food posting a 16% gain.  However, the company noted that dry volume growth was more a function of timing, based on sell-in shipment dates. For the full year Blue Buffalo anticipates that wet food and treat growth will outpace the growth of dry food from a percentage standpoint. Gross Margin was 0.4% higher than the same period in 2014, though 0.7% lower than 1Q2015 due to the ramp-up in the companies owned production facility (Heartland).  The balance of the Operating Income compression is explained by IPO related expenses, investments in new product introductions, and brand related expenses.
  • Freshpet also reported strong second quarter sales and earnings performance.  Sales for the quarter totaled $28.4 million, or 39% growth versus the same period in 2014.  Approximately 4.8% of this growth was attributable to new product tests, as the company seeks to enter the kibble sub-segment. Freshpet reported a 9.1% increase on Operating Margin as losses narrowed. However, the company experienced a 1.3% decline in Gross Margin versus the same period in 2014, driven primarily by mix.

While these three data points do not reflect all brands or channels, they do provide us a reasonable cross section from which to extrapolate. If we compare these results to the APPA projections for 2015, it would seem we are on track to meet or exceed projected growth in the largest category of pet spending.  For calendar 2015, the APPA projected total industry growth of 4.4% and 3.5% growth within the consumables.  If the largest industry player is growing 4.9%, albeit globally, and two key emerging but established independents are growing at healthy double digit rates, it would seem to augur for an up year in pet consumables. For further triangulation, we add to this the J.M. Smuckers disclosure that its Big Heart Brand’s acquisition is growing at a 4% – 5% annual rate. In the future, a publicly traded Petco, will only further add to our ability to predict in year category performance.

The above certainly does not represent perfect science, but in the absence of real time data, it does provide me some comfort as it relates to anticipated annual growth for the industry.

/bryan

Note: This blog is for informational purposes only. The opinions expressed reflect my view as of the publishing date, which are subject to change.  While this post utilizes data sources I consider reliable, I cannot guarantee the accuracy of any third party cited herein.

fresh2Earlier this month, pet food marketer, Freshpet pulled off a successful initial public offering, raising $156 million. The company, which generated $74.5 million in sales and $23.1 million in losses for the 12 month period ended June 30, 2014, priced its IPO at $15, higher than the anticipated $12 – $14 range. The stock enjoyed an opening day “pop” of approximately 27%.  Freshpet occupies some pretty attractive real estate in the form of 12,500 branded refrigerators.  Those units include distribution (as of September 30, 2014) in Wal Mart (1,607 stores), PETCO (1,364 stores), PetSmart (1,306 stores), Target (1,157 stores), Kroger (972 stores) and Whole Foods Market (226 stores).  The company was backed by Mid-Ocean Partners, a New York based private equity fund, who, for all intents and purposes, salvaged the company in 2011 after it burned through the original undisclosed investment it received from Tyson’s Foods, who is the primary protein supplier to the company and remains a minority shareholder.

At is current enterprise value of $676 million (November 24, 2014), Freshpet’s public equity trades at 9.1x multiple of revenue.  In contrast, publicly observable acquisition multiples for the most attractive pet food assets have historically topped out at 3.7x revenue (Del Monte Foods / The Meow Mix Company, March, 2006). This convergence of circumstances has led many too ask, often using colorful language, how the market might justify such a premium. Here is my response:

  • When a Number if Not the Number. When a company goes public, there is a collaborative process to create positive momentum for the stock price.  The supply chain has the company selling at a discount to the underwriter who in turn sells at a discount to institutional investors and sprinkles some of the well connected general investing public. Those not in this inner circle who seek to access the stock are forced to bid it up in an effort to acquire a position.  The resulting supply/demand imbalance generally buoys the stock price for some period, ideally until fundamentals catch-up to the price. In the period immediately following a public offering, there is limited downward pressure, outside of broader market fundamentals, on the stock until it posts earnings or the lock-up period expires. As such, the prevailing price is simply the price you can buy or sell the stock for right now rather than indicative of the long range, or fair-market valuation of the company.  You can see other examples of this trend in practice with other recent pet related IPOs Pets-At-Home Group (LSE:PETS) and Trupanion (NYSE:TRUP) both of which, after a brief honeymoon period wherein the stock was supported by the supply/demand imbalance, have seen their multiples revert to the mean for their business respective models.
  • Don’t Underestimate the Pent-Up Demand. Retail investors love the pet space because, for companion animal owners, it is easy for them to understand. However, as we have detailed before, there is a lack of pure play pet companies, especially in the consumables category.  Investors can play the retail space through PetSmart (NasdaqGS:PETM) and Pets-At-Home, the health care space through VCA Antech (NasdaqGS:WOOF), Zoetis (NYSE:ZTS), and Neogen (NasdaqGS:NEOG), and distribution through MWI Veterinary Supply (NasdaqGS:MWIV). However, opportunities to invest directly in pet food and treats are non-existent.  The three biggest players — Purina (subsidiary), Mars (private), and Big Heart Brands (private) do not currently offer that opportunity. As someone who subscribes to the Peter Lynch theory of investing (i.e., go with what you know) I can see why retail investors might be willing to pay a premium to get access to the sub-sector given its growth profile, consolidation multiples, and recession resistant dynamics.
  • Compelling Business Attributes.  What is overlooked in the analysis above is the fact that Freshpet has some compelling business attributes that should be ascribed a premium price.  The company’s refrigerator inventory occupies some valuable real estate and the business model is such that retailers are unlikely to support multiple players, providing Freshpet with a first mover advantage and considerable barriers to entry once that cost is underwritten.  Ultimately, the company might become a toll taker whereby it is paid to host third party products in its established real estate. Also consider that Freshpet reports that its refrigerator units reach cash flow breakeven in 15 months. If we assume the company will generate approximately $81.6 million in sales this year (the most recent reported quarter (2Q2014) annualized), this translates to approximate $18/per refrigerator/day to support this breakeven point.  One and one half six pound tubes of the company’s Vital brand would essentially cover that daily revenue bogey.  As revenues scale breakeven per refrigerator will come more quickly, thereby enhancing cash flow.  Finally, the cost premium, while significant is not that far out of market for owners already feeding their pet super premium solutions.  Consider that an active 50 pound dog would go through at 28.6 pound bag of Orijen premium pet food (made by Champion Pet Foods) in 23 – 27 days (based on the brand’s feeding guidelines here) at a cost of approximately $3.75 – $4.25/day based on an in-store retail ring with sales tax.  That same active 50 pound dog would go through a six pound tube of Freshpet Vital in 4 – 5 days, at a cost of approximately $3.50 – $4.40/day. While the disparity gets larger with the size of your dog or as you indulge in more exotic Freshpet offerings, and the price variance is much greater versus mass market kibble, it is not all that out of line for a premium consumer.

The net of all this is that the current equity price of Freshpet is hard to fathom.  While the current price is being artificial inflated, the business has some operating characteristics that support a premium.  I won’t hazard to guess what Freshpet will be worth once the trading shackles are off, but we have seen examples of where companies that are pioneering unique niches in the food space can enjoy strong multiples from some time (see Annie’s).  However, invariably company performance will have to accelerate meaningful to support even the prevailing enterprise value.

/bryan

Note: This blog is for informational purposes only. The opinions expressed reflect my view as of the publishing date, which are subject to change.  While this post utilizes data sources I consider reliable, I cannot guarantee the accuracy of any third party cited herein.

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